Three and a half years have passed since the afternoon when the stock markets went into a trillion-dollar free fall and just as suddenly reversed course, recovering 80 percent of that loss. It all happened in less than 45 minutes.
The "Flash Crash" of May 6, 2010, was the unintended result of high-frequency trading (or HFT), in which heavy-duty computers execute sophisticated trading strategies in millionths-of-a-second time frames. HFT has been the source of many smaller crashes and other mishaps, occasionally shutting down trading venues and even putting firms out of business. Yet the practice continues to grow, while the transaction times get shorter and shorter.
A few weeks ago, the Commodity Futures Trading Commission, which has jurisdiction over almost all derivatives markets under the Dodd-Frank financial reform law, published a paper evaluating various "kill switches" that might contain the damage when the machines go haywire again.
When, not if, because, as the CFTC's Concept Release points out, HFT trader bots now control more than 90 percent of all exchange-traded derivatives – the "financial instruments of mass destruction" that Warren Buffett warned about, five years before the 2008 crash proved him right. In other words, we have reached the point in the sci-fi movies when the machines truly take command of the nuclear arsenal.
So it is time to ask a few basic questions about HFT. Starting with: What good is it? How does society benefit when we reduce the average trade-completion time from, say, 125 milliseconds to 5 milliseconds?
By society, I do not mean a single financial institution or even the entire financial sector. The increasing speed of transactions is driven by competition among trading firms. Speed is crucial to any trader's ability to act before other traders do. But no one has identified an advantage to the overall functioning of the markets or the wider economy when traders get sucked into an "arms race" of escalating speed and automation. In fact, even the most passionate HFT advocates would largely agree that the public ceased to benefit several developmental stages ago.
The case for this type of trading rests on the premise that it lubricates the markets by adding more "liquidity." A liquid market, however, is characterized by plentiful and reliable offers to both buy and sell; it must be balanced, since the market crashes if everyone wants to sell at once.
No doubt, HFT increases volume by allowing transactions to be made and reversed with blinding speed. But volume and liquidity are very different. In markets dominated by HFT, new information stimulates the trading algorithms of multiple firms, which behave like herds of impala stampeding across the Serengeti, this way and that. Prices jump up and down until the pointless activity peters out. The Flash Crash was no more than an extreme example of what goes on day in and day out in today's markets.
